Businomics Blog

Financial Regulation: Paulson Misses the Trial and Error Economy

This new regulatory proposal from Treasury Secretary Paulson reminds me of the Patriot Act.  The department has a laundry list of changes it wants.  Then there's a crisis.  At which point the department pulls out its laundry list and says, "This is the solution to our crisis."  In reality, it's just the plan that they had on the shelf for a year.  If it really would have prevented the crisis, then the Treasury Secretary should be fired for failing to push harder to get that plan passed earlier.  But of course, that's not the case.

The Wall Street Journal editorial has the key insight into financial regulations:  the market is doing its job.  People say to me, don't we need some regulation to prevent lending to people who cannot afford the loans?  Here's what happened.

1. Lenders experimented with loans to people of lesser credit quality.
2. It worked in the initial stages, so the experiments were expanded into programs.
3. The large-scale programs failed miserably, causing billions of dollars of losses to the people who invested in the loan program.

Now, do we need laws to keep these investors from lending money to subprime borrowers?  I don't think so.  It will be years before those investors will touch that stove again.

If investors won't participate in large subprime lending schemes again, what would be wrong with some regulations?  After all, a regulation that prohibited me from hitting myself in the head with a hammer would not really crimp my recreational choices.  Here's the rub:  entrepreneurs need to experiment.  Some folks who are subprime may really, truly, be good credits.  If we regulate that loans can only be made to people with good credit, then lenders cannot experiment to find out if maybe they should change their lending guidelines.

A key element of our trial and error economy is that good business practices cannot be fixed in stone.  Companies experiment, try tightening a little, try easing a little, look for under-served markets.  For example, take "stated income" loans, in which the lender took the borrowers stated income at face value, without verifying the facts.  Sounds pretty stupid in retrospect.  So let's make a law that income has to be verified.  However, you've just redlined those folks with income that is inherently unverifiable: strippers, street performers, flea market vendors, etc.  We should allow lenders to test the waters with these people.

(If you are not a regular reader of the blog, take a look at some of the articles in the "trial and error economy" theme.)

Insurance regulation?  Part of the plan is a new federal insurance regulator.  What's the problem here?  My car insurer, home insurer, life insurer, are now regulated by my state.  I have not heard of any crisis, scandal or problem here.  This is another case of a "crisis" being used to justify totally unrelated regulatory changes.

Secretary Paulson says the plan will "reestablish the federal government's role in regulating the insurance industry by reclaiming a portion of its delegation of insurance regulation to the states..."  Whoa.  I'm not a lawyer, but I'm stunned that the Treasury Secretary thinks this way.  The constitution does not grant to the federal government authority to regulate insurers, aside from the federal government's authority over interstate commerce.  There has been no delegation of power from the federal government to the states, because the federal government never had it.

Bear Stearns Bailout: It's Not Who You Think

The quick read from the press is that the purchase of Bear Stearns by JPMorgan Chase was a "bailout."

Jim Hamilton over at EconBrowser doesn't buy that story.  He says, "$2 a share is no bailout, but instead represents a fire sale price."

I buy that, because Bear had been selling for $57 a share two trading days before the buyout.

But there's more to the story from the New York Times (hat tip to Barry Ritholtz):

Holders of the more than $300 billion in Bear Stearns bonds, in the meantime, are purchasing Bear stock to strengthen their hand in voting for the deal, thus guaranteeing that their bond investments will retain the backing of JPMorgan and its guarantor, the Federal Reserve Bank of New York.

That's who is getting bailed out: Bear's creditors, clients, and counter-parties.  The people whose due diligence was not very diligent.  The people who could help us avoid another debacle by being very, very careful in their credit analysis.

But no, care need not be taken.  If you are doing business with a large investment bank, don't worry. The Fed will bail you out if you are stupid enough to lend credit to an insolvent institution, or if you ask an insolvent institution to hold your securities, or if you pick an insolvent institution to be your counterparty in a derivatives contract.

Dr. Ben rode to the fire in a big red truck.  But his truck was leaking gasoline all over town, setting up the street for another major conflagration that could be far worse than the Bear Stearns fire.

Someone should have pulled Bernanke aside and told him to chill.  The economy is pretty resilient.  It can withstand a lot of turmoil.   Instead, the chairman is too afraid of financial turmoil, and as a result, he's going to get more of it.

Incentive Systems: Markets, Medicare, and Your Business

"Markets and Medicare" is a great article in today's Wall Street Journal by my good friend John Goodman, president of the National Center for Policy Analysis.  The article has value beyond the Medicare debate, but let's first key in on those issues.  Dr. Goodman explains how medical costs can be lowered and health outcomes improved by freeing doctors, freeing patients, and freeing entrepreneurs.  Our rigid compensation system often will not pay for the most cost-effective treatment methods, so we get locked into expensive and less effective treatments.  Not good, of course.

If you're not interested in Medicare, here's how you should read the article:  your current relationships with employees, vendors, joint venture partners, and customers may also be too rigid.  If someone in the network of relationships around your company has a new idea, will the compensation structure allow that idea to flourish?  Do cost savings techniques get rewarded, especially if they increase customer satisfaction?  It may be time to take a fresh eye to your contractual arrangements.

The essence of economic progress is the Trial and Error economy (described in a series of articles listed here, my favorite of which is this one.)  Successful companies set up systems to encourage lots of little experiments in cost savings and customer satisfaction.  The experiments measure results, so that the winners are pursued, the failures are dropped, and progress is continuous.

Which Presidential Candidate Is Best for the Economy?

One the candidates said he would "jump start the economy."  I can't remember which one, because I switched to Pro Wrestling for a dose of reality.  The image the candidates offer is that of a skilled operator maneuvering the levers of the economy from the oval office.  Kind of like someone operating a backhoe, but without the hard hat.

Robert J. Samuelson's recent column in the Washington Post exposes this fallacy quite nicely:

We have a $14 trillion economy. The idea that presidents can control it lies between an exaggeration and an illusion. Our presidential preferences ought to reflect judgments about candidates' character, values, competence and their views on issues where what they think counts: foreign policy; long-term economic and social policy -- how they would tax and spend; health care; immigration. Forget the business cycle.

Shrinking Middle Class? Drew Carey Says No

I wouldn't normally look to a comedian for economic commentary, but Drew Carey combines an interview with economist Michael Cox with some eye-opening interviews with . . . maybe they were fat cats or maybe the middle class. 

Watch the video (from Reason.tv) and see for yourself. (Hat tip to Russ Roberts.)

Economic Policy: Obama and Clinton

Today's Wall Street Journal has columns by Hillary Clinton and Barack Obama's advisors.  In a post last week I chided Mitt Romney for glib generalities.  Now Clinton gives us the opposite extreme:  government by laundry list.  Remember some of the awful State of the Union speeches, in which the President (pick any recent president you wish) says: "There's a problem with X; I have a new program.  There's a problem with Y; I have a new program.  There's a problem with Z; I have a new program."  Well, that's Hilary's column.  I liked the internal consistency of her message at first, in that she presented a broad area of concern, then specified action steps to deal with the area.  That appeals to my analytical side.  But she shows no real philosophy about how government should operate, merely that for every conceivable problem there should be a new government program.  Gag.

If you don't like laundry lists of specifics, then Obama is your man.  He apparently believes in content-free leadership.  His major theme: bringing people together.  Ending the divisive partisanship that infects Washington DC.  I'm not sold that a) he can end partisanship, and that b) we'll get better policy without partisanship.  He has not made that case (it would require specifics, which Obama isn't in to).  I confess that I really miss the Bill Clinton administration, when gridlock prevented action and we were all focused on that blue dress.  Remember, the economy was strong and the budget was in surplus while Congress was gridlocked.  Sigh.

Obama's other major theme is change.  Now, I'm a change kind of guy.  Shake things up, turn 'em on their head.  Fine.  But for a presidential candidate, I think you have to ask, "Change from what, to what?"  Another one of those pesky points that Obama is too big to deal with.

The two columns help illustrate the major difference in style between the two candidates, which I posted about last month, describing David Leonhardt's New York Times article.

Thankfully, I don't have to vote in the Democratic primary.  I'm afraid I'd write in Ron Paul.

McCain and Romney on Economic Policy

Today's Wall Street Journal has articles from the McCain and Romney campaigns outlining the candidates' policies. (Available without subscription: McCain article, Romney article.)  I don't have a dog in this fight (well, I do, but it's neither McCain nor Romney), but I'm struck by the differences in style between the two columns.

The McCain column is a list of actionable steps: McCain will propose these tax changes, McCain will veto pork-laden bills, McCain wants to engage in further trade negotiations.  These are actions that a president can take.  Whether good policy or bad, we can see if he's doing what he said he would do.

The Romney column promises much more: "Mr. Romney will strengthen families in America."  "... he will make sure that our children have great schools ...."  Although the article specifically endorses tax cuts, it's mostly generalities.

When a candidate promises grandiose results, I get nervous.  I wonder: is he so stupid that he thinks he can deliver on those promises, or is he intentionally lying for political gain?  In short, is he George W. Bush or Richard M. Nixon?  I think I'll vote for Tricky Dick this time round.

Obama's Economic Advisor

Here's a good interview on CNBC with Austan Goolsbee, Senator Obama's chief economic advisor.  I don't buy his proposals, but he explains them fairly well here.

Warning: what a political candidate's economist says is not likely to be what the elected official does.  Anyone remember Nixon's wage and price controls, or Bush's steel tariffs?  Nixon's and Bush's economic advisors would rather have their daughters turn out like Britney Spears than have their president adopt such stupid policies.

Obama and Clinton: Economic Policy Differences

The economic policy difference between Senators Obama and Clinton is explained nicely in a New York Times article by David Leonhardt.

Short summary: both believe in a big role for government, but Clinton tends to favor well-crafted, specific programs.  Obama, in contrast, prefers broader, simpler programs that don't rely on people to learn the specifics of the programs.

Any government program will have unintended consequences.  One of them is that if you set up a program for people who meet a specific profile, and estimate that exactly 1.34 million people fit that profile, you will find that another 2 or 3 million people adjust their own profile to fit the program.  Now your costs are 2x or 3x what you had budgeted. 

The solution (for those who insist on this government program) is to write more details, limitations, exclusions and sliding scales.  One result, however, will be people you really wanted to help who don't fit.  So what do you do?  You've got it.  Set up another program. 

For instance, how many different government programs does the government have to help parents pay for their children's college educations?  There are Coverdell plans, special savings bonds, 529 plans, special exceptions for IRAs and Roth IRAs, Hope Scholarship Credit, Lifetime Learning Credit, and I don't know what I've missed.

So which approach is better?  Obama's approach will lead to large-scale misapplication of funds.  Clinton's will result in a bewildering array of confusing programs.  Take your pick.

Trade With China: I Signed the Petition

I am one of 1,028 economists who signed the Club for Growth's petition opposing retaliatory tariffs or trade barriers with China.  Here's the text:

     PETITION
Concerning Protectionist Policies Against China

We, the undersigned, have serious concerns about the recent protectionist sentiments coming from Congress, especially with regards to China.    

By the end of this year, China will most likely be the United States' second largest trading partner. Over the past six years, total trade between the two countries has soared, growing from $116 billion in 2000 to almost $343 billion in 2006. That's an average growth rate of almost 20% a year.    

This marvelous growth has led to more affordable goods, higher productivity, strong job growth, and a higher standard of living for both countries. These economic benefits were made possible in large part because both China and the United States embraced freer trade.    

As economists, we understand the vital and beneficial role that free trade plays in the world economy. Conversely, we believe that barriers to free trade destroy wealth and benefit no one in the long run. Because of these fundamental economic principles, we sign this letter to advise Congress against imposing retaliatory trade measures against China.    

There is no foundation in economics that supports punitive tariffs. China currently supplies American consumers with inexpensive goods and low-interest rate loans. Retaliatory tariffs on China are tantamount to taxing ourselves as a punishment. Worse, such a move will likely encourage China to impose its own tariffs, increasing the possibility of a futile and harmful trade war. American consumers and businesses would pay the price for this senseless war through higher prices, worse jobs, and reduced economic growth.    

We urge Congress to discard any plans for increased protectionism, and instead urge lawmakers to work towards fostering stronger global economic ties through free trade.